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Friday, November 27, 2009

Back in the heady days of 2006 some 30,000 cranes, roughly a quarter of total global capacity, were busy whirring away in Dubai. Today most of these devices have either left to find service in other parts of the globe, or lie silent, unused and unloved. In what is only the latest sign of the ongoing property snarl-up affecting the emirate Nakheel, Dubai World’s property developer subsidiary, asked on Wednesday for a delay in their next debt payment. The move was widely seen by investors as a technical default, raising concerns about investment in risky assets right across the globe. So while their company slogan may well be that the sun never sets over Dubai World, the fact is that Dubai World’s sun not only no longer shines, it is suffering from something more like a total eclipse.

According to the last reckoning, government owned Dubai World has some $59 billion in outstanding liabilities, making the company responsible for the lion’s share of the total $80-100 billion in estimated Dubai state debt. Up to now all maturing government-linked debt has been paid off in full, with government funds making up any shortfall in private funds. But the latest announcement suggests that weaknesses in the global property sector and vulnerability of the emirate’s economic model is leading the government to have second thoughts, and the clear impression is that Nakheel could be a very different story given the government's expressed intention of supporting only viable companies.

More than the scale of the issue, the problem this week in Dubai has been the uncertainty created, the underlying lack of transparency about the state of corporate and national finances and about exactly which debt will be honored, and above all about whether or not other countries – both within and outside the region - will be affected via the process known to financial analysts as contagion.

The consequences of the present payment standstill are wide ranging, as would be the impact of any eventual default. The repayment of Dubai World's $4 billion Nakheel bond was seen by investors as a key test for the emirate's ability to deal with the rest of the $80 billion or so owed by the government and its state-controlled companies. Dubai’s ability and willingness to do just this is what is now in doubt, and the way the process has been handled so far is leading to all manner of investor speculation.

The blow caused by the announcement was initially softened by news earlier the same day that the government had raised $5 billion from Abu Dhabi banks, but this optimism was soon dented as it sank in that the figure was considerably less than what the emirate had been hoping to attract from external investors and the sequencing of the two announcements is interpreted as suggesting that the Abu Dhabi money will not be spent on companies like Nakheel and Dubai World.

Indeed Dubai's growing problems had been evident for some time, with the credit rating agencies sharply downgrading Dubai government-owned corporations over the last year as expectations for the extent of likely government support have declined. Earlier this month Moody’s cut the ratings on Dubai Ports World, and Dubai Electricity and Water to Baa2 (junk status) from A3 and downgraded 4 other government linked companies, with the agency noting in its press release that the debt restructuring plan "highlights the government's intention to strictly adhere to its stated policy of supporting only those companies with viable long-term business prospects”

The question is, of course, now that the emirate's lop sided growth model has been shown to be completely dysfunctional, what are the viable long term business prospects in a city with so much excess capacity as far as property goes. According to the Dubai Statistics Center, the total population was 1,422,000 as of 2006, of which 1,073,000 were male and only 349,000 were females. Evidently activity associated with the construction industry can offer some part of the explanation for this massive gender imbalance. Just under 20% of the population are estimated to be UAE nationals. Approximately 85% of the expatriate population (and 71% of the emirate's total population) is thought to be Asian, chiefly Indian (51%), Pakistani (15%), Bangladeshi (10%). This impression of a large construction industry oriented population is reinforced by the economic data. Although Dubai's economy has been built on the back of the oil industry, revenues from oil and natural gas currently account for less than 6% of the emirate's revenues. It is estimated that Dubai produces 240,000 barrels of oil a day and substantial quantities of gas from offshore fields. The emirate's share in UAE's gas revenues is about 2%. But Dubai's oil reserves have diminished significantly and are expected to be exhausted in around 20 years. Real estate and construction account for about 23% of GDP and financial services for another 11%. Assuming many of the builders will now leave, it is hard to see what the future actually holds. Like countries a lot nearer to home - Spain, Ireland, the Baltics - it is hard to know what exactly to do with an economy which has been totally distorted by construction activity, and unsustainable building and price rises. And of course Dubai's problems are a lot larger than anything which is to be found in Europe.

Will We See Contagion?

Aside from the Dubai issue itelf the big worry now is possible contagion to other markets, with Central and Eastern Europe in the forefront of everyone’s mind, given the overlap in bank exposure. The announcement also lead to a sharp a drop in the value of the UK pound (hat-tip to Izabella Kaminska at FT Alphaville - see chart below) on the fear that the Dubai government could be forced into a rapid sale of its international real estate, since the emirate is perceived as having extensive UK property holdings which market participants (rightly or wrongly) think may be in danger of going under the hammer in a move which could clearly have implications for the UK property market, and the banks that have exposure to it.

In total European banks are estimated to have some $40 billion of exposure to Dubai with Standard Chartered leading the group according to research from Credit Suisse. HSBC Holdings, Barclays, Royal Bank of Scotland Group and Lloyds Banking Group also have some, significantly lower, exposure.

Since the decision to halt payments has raised fears of the largest sovereign default since Argentina 2001, most of the attention has been focused on sovereign debt issues, and these, of course, extend far beyond the Middle East itself. In particular European bond market worries grew over the ability of riskier government borrowers from Russia to Greece and Italy to pay back their debts in the longer run. And it is just here that one of the long term consequences of what happened this week in Dubai can be found, since with government after government pressing the accelerator pedal hard to the floor on the stimulus front, and digging ever deeper into the public purse to plug gaps in the bank balance sheets, the perception that paying back all the accumulated debt may be harder than expected, especially with ageing population problems to think about, is now gaining traction among investors. And once sovereign debt default fears really come up over the investor radar, it is going to be very hard work to remove them.

Greek sovereign debt in particular is attracting a great deal of attention, and this week one historic milestone has been passed, since the cost of insuring Greek debt for the first time equalled that of insuring equivalent Turkish debt. At first sight this is very shocking news, since as recently as 2007, the Turkish CDS spread was trading at about 500 basis points on perceived fiscal risks. The Greek spread, by contrast, was nearer 15bp. The country is, after all, a member of the European Monetary Union, and its euro-denominated bonds were considered effectively protected by other euro states. But over the past year the fiscal position of many emerging markets nations, Turkey among them, has become more favourable, while that of some Eurozone countries, including Ireland and Spain as well as Greece, has steadily deteriorated.

Evidently - as the Financial Times's Gillian Tett points out - such comparisons, apart from constituting a fairly bitter blow to Greek pride, raise a much bigger issue, one which goes straight to the heart of the Dubai saga. Two years ago, global investors generally did not spend much time worrying about the risk that seemingly remote, nasty events might occur. But the financial crisis has changed this perception. Having had their fingers badly burned once, investors are eager not to have it happen a second time, which is why what is happening in Dubai now makes them nervous, and why Europe’s governments would do well to think more about the future, and especially about ensuring that we don’t see Dubai like events starting to happen much nearer to home.

Thursday, November 26, 2009

“Cutting rates by 50 basis points here and there is not going really diminish the appeal of the ruble,” said Manik Narain, an emerging markets strategist at Standard Chartered Bank Plc in London. “In terms of nominal interest rates Russia (at 9% as of 24 November) is still offering the highest yields in the emerging market space and in an environment where oil prices are remaining relatively well supported we think that the ruble will continue to be seen as an attractive way to position for global recovery,”

The world's central banks are having a hard time of it these days, having just gotten through the worst banking and financial crisis in living memory they now face a growing dilema between continuing to give support to the developed economies (which are yet to recover from those early hammer blows) and the danger of creating fresh global asset price bubbles in emerging economies, asset bubbles which could easily be being fuelled by low US interest rates and a weak dollar. The latest warning in this respect comes not from Nouriel Roubini (or even from me, but see this post, and this recent interview I gave on Forex Blog), rather it emmanates from Germany’s new finance minister, Wolfgang Schäuble. His comments - which were cited in last Saturday's Financial Times - highlight official concern in Europe that the exceptional steps taken by central banks and governments to combat the crisis carry with them a series of undesireable side effects.

Such openly expressed concerns only add further weight to recent statements made in China, where only a week ago the banking regulator Liu Mingkao explicitly criticised the US Federal Reserve for indirectly fuelling the “dollar carry-trade” – a process whereby investors borrow dollars at ultra-low interest rates in the United States and the invest them in higher-yielding assets abroad.

Wolfgang Schäuble went even further, saying it would be “naive” to assume the next asset price bubble would look just like the last one. “More likely today is a scenario in which excess liquidity globally creates a new [sort of] asset market bubble.” he said, and the fact “ that low interest rate currencies such as the US dollar increasingly being used as a basis for currency carry trades should give pause for thought. If there was a sudden reversal in this business, markets would be threatened with enormous turbulence, including in foreign exchange markets.”

As I argued in my last post on the carry trade, the danger of a short term sudden reversal may be being overstated at this point, since exit from emergency life support will be at best slow and measured in the United States, while ample funding will continue to remain available in Japan, where the central bank has now formally recognised that the economy is once more back in deflation (officially it exited in 2006, and the Bank did manage to summon up a full half percentage point worth of interest rate rise before falling back towards zero again, but in reality, if we strip out the oil price impact, the sad truth is that Japan never really left deflation).

However, regardless of whether or not we are running the danger of having an overly rapid unwind effect, untold damage is in fact being done, with the structural distortions being produced by the massive “wall of liquidity” which is currently sweeping the planet being evident enough, showing up as it is in some unexpected places, like Russia for example.

Ruble Once More On The Rise

On the face of it the idea that investors who were rushing for the Russian door following the Roki tunnel incursion back in August 2008 may now be rushing back in again may seem hard to believe, particularly given the serious economic recession which followed, and in reality it isn’t quite like this, but what is clear is that a steady and significant flow of funds is now most definitely heading in Russia’s direction - even if the immediate objective is not to increase what Russia most definitely needs, namely capital investment. A brief glance at the charts for movements in the ruble vis a vis the US dollar (see below) shows immediately what has been happening. After hitting a low of $31.39 on September 2 the ruble has been steadily rising, and was at $28.65 on November 11, since which time it has been hovering, as investors vacilate waiting to see where policy and the currency go from here.

At the same time, if we look at movements in the ruble-USD over a longer period of time (2 years in the chart below) it is plain the the ruble hit bottom on 4 February 2009 at $36.22 after falling steadily from 17 July 2009 when it touched $23.25.

In fact, as I say, while it is clear that Russia is on the receiving end of a steady inflow of funds, it is far from clear that these funds are of the kind she most needs at this point. Much of the money has been going into stocks, and Russian equity funds drew record amounts at the end of October, according to data provided by EPFR Global. In fact Bloomberg data show that the ruble has been the second-best performer among emerging market currencies after the Chilean peso over the past three months, gaining 8.7 percent in the period. And even foreign currency purchases from the central bank and lowering interest rates systematically to a record low (in Russian terms) has not worked. Indeed Russia's foreign currency reserves have now risen to $441.7 billion (as of Nov. 13) compared with the low of $376.1 billion reached on March 13. Whilethe Micex Stock Index has gained 116 percent this year, making the Index the best-performing benchmark equity measure globally since January (in local currency terms), again according to Bloomberg data.

In comparison Russia’s foreign direct investment plummeted an annual by 48.1 percent, the most on record, to just $10 billion in the first nine months of the year, while overall foreign investment, including credits and flows into securities markets, was $54.7 billion, down 27.8 percent when compared with the same period a year earlier,according to Federal Statistics Service data. Other foreign investments, including loans from foreign banks and Russian companies’ foreign divisions, were down 20.9 percent in the period to $43.7 billion. The consequence of all this is that the decline in investment activity has been - as can be seen in the GDP growth components chart below - perhaps the greatest single drag on the domestic Russian economy over the past twelve months.

But, as I am stressing this earlier overall impression of Russia as a country with problems of net capital flight now no longer gives us a precise up-to-date picture because, in a reversal of the earlier pattern Russia has seen, since mid September, significant capital inflows. In this sense some of the aggregate flow data is misleading, and even while the pressure from foreign lenders to repay sindicated loans continues and Russian borrowers continue to have difficulty rolling over their debt, the aggregate capital flow data to some extent masque a change in the underlying structure of Russian external debt - here, as ever, the devil lies in the details. As Guillaume Tresca, a Paris-based emerging market strategist with Credit Agricole’s Caylon Unit, argues the mounting weight of that huge wall of liquidity sweeping the planet means that something somewhere has to give, with the consequence that the Russian authorities are now under severe pressure to accept the inevitability of short term ruble appreciation since even though they “will try to do what they can to smooth the process, it’s very hard for them to go against the flow” since current “capital inflows are massive.”

In fact a growing consensus seems to be now emerging that Russia’s central bank will find itself forced to accept a stronger ruble next year as the devastating cocktail of rising commodity prices and abundant liquidity simply prove to be too powerful a force for policy makers to counter. So while representatives of the Russian administration have repeatedly asserted that they will do all they can to cap the ruble’s advance, all may well not be enough, despite Vladimir Putin's repeated declarations that his government won’t allow excessive appreciation in a bid to give some support to struggling exporters. The Canute like task of driving back the ocean is hardly an easy one, and, as the IMF itself recently warned, all efforts to fight the ruble’s advance may simply prove to be “unproductive.”

The problem has recently become even more complicated since, in the short term at least, letting the rouble rise also has its attractions for a Russian administration faced with simmering popular frustration with their inability to get the ongoing economic contraction fully under control. A rising ruble means slower inflation and more spending power for domestic consumers, consumers who have yet to get over the record 10.9 percent economic contraction which hit them in the second quarter. Given that the nine interest rate cuts introduced by the central bank since April have manifestly failed to unlock the credit flow to consumers as banks hold back their lending on concern borrowers can’t repay their debt (see chart below) a rising exchange rate certainly seems to be worth a second look as a way forward, since while a higher exchange rate coupled with near double digit inflation may cripple manufacturing competitiveness, it does transfer incomes directly into people’s pockets, something hard pressed politicians might see as quite beneficial.

Lending is still - as can be seen in the above chart prepared by the World Bank for its latest report - a problem, and corporate (or non-financial corporation lending) fell by 0.7 percent in September from August continuing the ongoing decline. Lending to households dropped 1.1 percent making the eighth consecutive monthly decline, with year on year levels now in negative territory, while non performing retail loans rose, climbing to 6.4 percent from 6.2 percent.

And the World Bank expect the many bank balance sheets will continue deteriorating as the share of non-performing loans increases. “In the environment of increasing credit risks, lending activities by the banks have remained limited despite improving liquidity conditions in the economy and continuing monetary loosening.” Bad debts in the banking industry may reach an average of 10 percent by the end of the year according to the Bank.

And when we look at ruble realities, as the IMF point out, efforts to stem the ongoing rise with intervention are far from being able to give the desired result. Bank Rossii bought a net $15.2 billion and 485 million euros in October, their largest foreign currency purchases since May, and went on to buy $6 billion during the first 17 days of November according to press reports citing central bank chairman, Sergey Ignatiev. Yet last week the Russian the ruble ended 0.1 percent higher at 35.0632 against the central bank’s target currency basket, its strongest level since December 23 2008. The ruble appreciated 3.4 percent in October against the dollar (for its second consecutive monthly gain) and has risen more than 1 percent so far in November. Thus the central bank has now moved on to use monetary policy to try and stem the rise, and said on October 29 that it would also use interest rates in an attempt to reduce the “attractiveness of short-term investments in Russian assets and stop the accumulation of risk”.

The recent rise follows ruble a 35 percent slump against the dollar between August last year and January, raising the cost of imports (which make up about 49 percent of the consumer goods sold in Russia) and, in theory, making Russia's domestic industry somewhat more competitive externally. However, without a sound institutional infrastructure, and a coherent monetary policy, short term devaluation gains can easily be turned into medium term inflation, thus defeating the purpose of corrective price devaluation.

The current problems are not of recent making, but are the logical end product of steady and systematic long term mismanagement of Russia's monetary policy, a mismanagement which has now created a veritable Procrustean bed of problems for both Russia's economy and the wider society. Warnings were frequent enough, but went unheaded, and the continuing failure to address the underlying inflation problem between 2005 and 2008 now means that large structural distrortions have been accumulated in the economy, including a massive one of commodity export dependence, a problem which effectively turned the country into a veritable disaster waiting to happen if ever there should be a protracted lull in the secular rise in energy prices. That lull has most definitely now arrived, since while it is obvious that Russia's short term future depends on energy prices, it is far from clear what the future holds for those energy prices themselves.

Weak global demand for oil has led to a sharp rise in excess capacity and OPEC's spare capacity has risen to levels not seen since 2002, when prices averaged USD25/barrel with OPEC’s pricing power staying very low. Up to now oil prices have remained in the USD70/barrel range, supported by OPEC output restraint and its stated desire to have prices reach what it calls "a comfortable level" - ie near USD75/barrel - as well as by expectations of rising demand. At its September 2009 meeting, OPEC left its production quotas unchanged but indicated it would take rapid action if prices dropped sharply. OPEC production, however, continues to edge higher, with compliance to its combined cuts of 4.2 million barrels per day falling to 66 percent in September from 71 percent in August. Thus there is evidence of OPEC strains and there is considerable uncertainty about real levels of 2010 demand, all of which makes for considerable uncertainty about prices. As can be seen in the above chart, World Bank oli price estimates (like their economic growth ones) have fluctuated, and have moved from a price estimate in March of around $62.95 for 2010 to the current (November) expectation of $75.29. While the earlier estimate may certainly be considered to be on the low side, the current one may well be too high, and a level of around $70 may not be an unrealistic forecast. It should be noted however that there are credible dissenters, and in a more or less reasoned analysis Capital Economics suggest that oil prices could well fall back again in 2010 to average somewhere around $50. If this forecast were to prove to be anywhere near correct, the Russian economy is going to be subject to major downside risks, due in particular to the difficulties posed by:

i) financing the fiscal deficitii) rising unemploymentiii) growing bad loans in the banking systemiv) refinancing external debtv) the continuing high level of consumer price inflation and the difficulties this poses for monetary policy at the central bank

Added to all this, the economy will clearly not rebound as easily as many seem to foresee, adding to the risk element on all fronts.

A Return To Growth In The Third Quarter

Following the deep output drop sustained in the first half of the year (10.4% of GDP year on year), the slow recovery in global demand and rise in commodity prices has helped lift Russia’s economy up from its earlier lows. But the recovery has only been a modest one, since preliminary data indicate that the economy still registered a 9.4 percent year-on-year drop in the thrid quarter, indicating only a very small improvement (possibly a seasonally adjusted 0.6%) over the second quarter. More recent data also point towards a rather uneven progression, with the manufacturing sector falling back while rising real incomes means that consumer demand is producing stronger growth in the services sector.

As in other countries, investment (both foreign and domestic) took a severe hit on the back of the credit crunch, and gross capital formation was indeedthe main demand side factor dragging GDP down in the first half of the year (by 14 percentage points), followed at some distance by consumption, which contributed 1.2 and 3.0 percentage points to aggregate output contraction rates respectively in the first and second quarters. Net exports, on the other hand, made a positive contribution (5.1 percentage points in the first quarter and 5.9 percentage points in the second) although as elsewhere the drop in imports was the key factor. When imports are looked at in volume (price adjusted) terms we find that real ruble depreciation (the real effective exchange rate depreciated by 5.9 percent in the first nine months of 2009) meant that the import contraction was more severe than it seemed, especially in the second quarter of 2009 when the drop in imports meant that net exports increased by 66 percent according to World Bank calculations.

Unemployment Falls Back, But Problems Remain

Six million Russians were added to the government’s official poverty count in the first quarter of this year alone, and by the end of 2009, 17.4 percent of the population or 24.6 million people will be living beneath the subsistence level of $185 per month, almost 5 percent more than before crisis, according to World Bank estimates. Unicredit analysts forecast that the number of Russians with disposable incomes of more than $1,000 per month will fall 48 percent this year to about 13.6 million, or roughly 9.6 percent of the population. Thus this recession is likely to have lasting and important results.

On the hand, employment statistics from the Federal Statistics Service indicate that a sharp downward adjustment in the labour market took place up to February this year, before moderating and then reversing. Unemployment seems to have peaked in February at 9.5 percent following the sharp decline in output, and the severity of the blow was especially strong in the industrial sector.

Since the beginning of March 2009, however, with real level of economic activity bottoming out (see above chart), the labor market continued to show moderate improvement: by September the number of those in employment had increased by 2.6 million, and the rate of unemployment fell to 7.6 percent, down significantly but still much higher than in September 2008 (5.8 percent). According to the World Bank this steady improvement is rather misleading as it reflects significant seasonal gains in employment and a shift in labor adjustment towards labor hoarding in the manufacturing sector.

As the World Bank also notes, the long term regional differences in Russian unemployment rates are striking ranging from a low of 1.6 percent in Moscow to a high of 52.1 percent in Ingushetia in August 2009. Traditionally unemployment is largely concentrated in the Southern, Far Eastern and Siberian federal districts. However, the crisis related unemployment shows a different pattern, with the largest increases in unemployment being found in the North Western District (from 4.8 to 7 percent) and the Urals (from 4.9 to 8.1 percent). Regression analysis carried out by the World Bank revealed that unemployment levels were higher in those regions with higher levels of manufacturing, and where industrial production accounted for a larger share of GDP.

And while it is entirely possible that the economy will show a “modest” recovery in the second half of 2009, this is “unlikely to have significant impact on social indicators,” according to the World Bank. Unemployment will increase to 9 percent “as seasonal factors wane” from 7.6 percent in September and it may take three years before the number of Russians living in poverty falls to pre-crisis levels, the World Bank estimates. Indeed, in the short term real incomes are “likely to fall further".

Monetary Policy Mess

The political threat posed by growing unemployment and rising poverty must most certainly be one of the reasons behind Russia’s central bank recent decision to lowered its key interest rates for the eighth time in six months, in a bid to both stimulate lending and to stem the inflow of funds and the rise in the value of the ruble which is making the work of restoring competitiveness to the manufactured sector all the more difficult. Earlier this month Bank Rossii cut the refinancing rate to 9 percent from 9.5 percent and reduced the repurchase rate charged on central bank loans to 8 percent from 8.5 percent. Despite the reductions Russia still has the fourth-highest benchmark interest rate in Europe after Ukraine, Iceland and Serbia.

The best thing that can be said about Russian monetary policy instruments is that they are hopelessly ineffictive. Even October consumer-price growth at 9.7% annually, while well down on the 15.1 percent peak hit in June 2008, is still horribly unacceptable, and it is extremely hard to understand how economic mismanagement and incompetence can have reached such a level that an economy which has been contracting at the rate of nearly 10 per cent a year can still have this kind of price inflation. There is no other word for it, this is a mess.

The bank is caught on the horns of a large dilema, since cutting rates further to stem inflows and the ruble rise may only risk fuelling more inflation, yet First Deputy Central Bank Chairman Alexei Ulyukayev stressed only this week (following the latest in rate decision) that the central bank did not exclude the possibility of further cutting its rates since it sees “no inflationary risks” next year and an inflation rate “much lower” than 9 percent. This follows explicit remarks at the end of October that the Bank was ready and willing to use interest rate policy as required to stem speculative capital flows that "threaten to undermine currency stability".

Inflation Woes

One small consolation at least in this ongoing mess is that pressure on Russia’s producer prices have been easing, and factory gate prices have even been falling. According to the preliminary data from the State Statistics Service, the price of goods leaving factories and mines was in fact down an annual 10.8 percent in August following a record 12.3 percent drop in July. Evidently The with the 2008 spike in oil and energy prices the logic behind this is easy to see. What is not so easy to see is why domestic prices take so long in responding to general capacity utilisation signals and why the Economic Development Ministry still seems comfortable with the expectation that average inflation will range between 12 percent and 12.5 percent in 2009 only marginally down from last year’s 13.3 percent. Stunning!

And while consumer price inflation has been tame in recent months this good behaviour may not last long, since it could rise more than expected in November, according to Deputy Economic Minister Andrei Klepach, who does not seem to completely share Alexei Ulyukayev price optimism. Consumer prices could rise "by about 0.3% to 0.4%" in November, Klepach said in comments recently, and this prediction seems to be near the mark, since according to the latest data we have consumer prices rose 0.1% in the week to 9 November, bringing to an end a period of just over three months without inflation. Looking into the future price growth may be further spurred by an influx of budget spending in the fourth quarter, as well as by a planned 30% increase in pensions which is due to come into effect on 1 December.

In fact, despite the fact that inflationary pressures have been easing in Russia in recent months, chiefly due to collapsing consumer demand and outlfows of capital following the crisis that hit the country a year ago, the official outlook for Russia's inflation in January 2010 is only that it will be "significantly below "the level of January 2009. This kind of argument is hardly reasssuring, since inflation last January was at an annual rate of 13.4%, although the short term outlook is for only a mild acceleration, with consumer prices increasing by between 0.2% and 0.3% in November and by about the same amount in December.

Why Not Devalue?

Well, one way not to solve the problem, according to European Bank for Reconstruction and Development Chief Economist Erik Berglof, would be a ruble devaluation, since despite recognising that the country has a very difficult couple of years in front of it, Berglof argued recently that “this (devaluation) is the wrong way to think about the recovery in Russia”.

As he said, Russia’s failure to wean itself off its reliance on commodity exports has condemned the country struggling to find economic growth in the face of a large drop in demand for its key export products. “If you want to have a flexible exchange rate, you need to get out of this dependence on commodities,” Berglof said. “It’s a major concern that in the last 10 years Russia has become actually more dependent on commodities. Unfortunately, not much progress has been made.”

Well, this is exactly the point, and is why I have been arguing over the last two year about how all those wage increases which the Russian administration seemed to rejoice in (since they bought short term popularity, and fuelled consumption) simply stoked-up the domestic inflation bonfire and in the process did untold damage to domestic competitiveness. However it is evident Russia's industries cannot now simply be transformed overnight, and this is where I find a weakness in Berglofs argument, since some remedy is needed to straighten out the distortions and get of commodity export dependence. But what? If it isn't devaluation, then surely we will need to see very substantial wage deflation in order to attract the now much needed inward foreign investment. The current position whereby prices rise by an annual 10%, and living standards are maintained by a sharp rise in the value of the ruble (making imports cheaper) is quite simply unsustainable, for reasons which should be evident from looking at the chart below. If you look at the green line (which shows the Real trade weighted Effective Exchange Rate) we will see how this has risen sharply since 2003, with the exception of the drop in the value of the ruble in the second half of last year. If we then look at the blue line (which shows the non oil and gas current account balance) we will see how this has been steadily deteriorating (again with the exception of the short sharp shock occassioned by the crisis of last autumn). However, as we can also see, the green (REER) line has now once more resumed its upwards march - the consequence of all those financial inflows, and the associated rise in the ruble - and with the upward march comes the ongoing structural damage to the economy, precisely the can't of structural damage which Erik Berglof would like to avoid, and even unwind.

Of course not everyone agrees with Berglof, and the Russian Association of Regional Banks, whose 450 members include the Russian units of Barclays and Citigroup, has called for a devaluation of as much as 30 percent. Billionaire Vladimir Potanin, realist and owner of 25 percent of OAO GMK Norilsk Nickel, said in recent interview with the Russian Newspaper Vedomosti that the “interests of the economy” will lead the currency to depreciate in the “mid term,” allowing exporters to cut costs and modernize production.

Nonetheless energy, including oil and natural gas, accounted for 69.1 percent of exports to countries outside the former Soviet Union and the Baltic states during the first seven months of this year, according to the Federal Customs Service, while metals were responsible for another 12%. So the commodities dependency is massive, and this situation can't be turned round easily.

Getting Carried Away By Global Liquidity?

Bank Rossi are also not 100% convinced by the merits of Berglof's reasoning, as witnessed by the fact that they facilitated a 35 percent depreciation in the ruble during the second half of last year (see chart below), and as the collapse in raw material prices and the dramatic change in local credit conditions first pushed Russia's economy into recession the ruble’s trading range was widened to between 26 and 41 against the dollar-euro basket.

However, as I keep stressing, the central bank is now locked on the horns of a massive dilemma, since as risk appetite returns, with it comes the enthusiasm for buying the so called "high yield" currencies - like the South African Rand, the Russian ruble and the Hungarian forint. Instruments denominated in all these currencies offer investors substantial returns at the present time thanks to offering some of the highest interest rates among globally traded currencies.

Indeed buying Russian rubles was one of the key recommendations made by Angus Halkett, currency strategist at Deutsche Bank in London, in a research report published back in April, and the market seems to have followed his advice The so-called carry trade works by investors borrowing in currencies with low interest rates and good prospects of continuing depreciation (the USD at the moment, for example) in order to buy higher-yielding assets, in countries with high domestic interest rates and continuing prospects for ongoing appreciation.

In general, engaging in one or other form of the thousand-and-one-varieties carry trade is pretty standard practice during times when returns for real economic activity are low, and central banks hold down rates and supply liquidity. Indeed we may include here the kind of carry practiced by banks in borrowing from the central banks only to then lend - for a small, but very low risk, interest rate commission - to their national government, who at this stage in the business cycle will normally be running a fiscal deficit. So more than funding recovery, the watchword at the moment is very much "carry on carrying".

But for those on the receiving end, the consequences of so much carry are far from innocuous, since the process simply funds all sorts of economic distortions, and far from allowing normal market corrections to occur, it simply amplifies the problem. Things are now becoming very detached from the so called "fundamentals" (whatever those might be in the topsy turvy world in which we now live), since it simply is not plausible that the currency should be rising in this way in a country with nine percent plus consumer price inflation and which badly needs to move away from commodity export dependency. The only conclusion which could be drawn is that the Russian economy now needs massive structural reforms, and on any imaginable scenario in the world in which I live these are simply not going to be implemented.

On the other hand Russia’s central bank may have to accept a stronger ruble next year as rising commodity prices prove too powerful a force for policy makers to counter and as consumer demand plays a bigger role in the bank’s decisions. The authorities “will try to do what they can to smooth the appreciation, but it’s very hard to go against the flow,” said Guillaume Tresca, Paris-based emerging market strategist for Calyon, the investment-banking unit of Credit Agricole. “Capital inflows are massive.”

Policy makers have indicated they will cap the ruble’s gains and Prime Minister Vladimir Putin has said his government won’t allow an excessive appreciation as exporters struggle to tap into a global trade recovery. Even so, efforts to fight the ruble’s advance may prove “unproductive,” the International Monetary Fund warned on Nov. 12, adding that “underlying factors” justify its strength. There is a growing consensus that Russia’s central bank is now close to accepting the inevitable, and will allow the ruble to continue appreciating to help domestic demand and cap inflation. As Clemens Grafe, chief economist at UBS in Moscow puts it, “A higher exchange rate, because it transfers incomes into people’s pockets, could actually be more beneficial,”

Fiscal Resources Near To Running On Empty?

According to preliminary estimates from the Ministry of Finance, the federal budget deficit totaled 4.0 percent between January and September, slightly below the expected level, in part due to the under execution of budgeted expenditures in the first three quarters of 2009. The federal non-oil deficit (which excludes drawing on oil revenues) amounted to 11.0 percent. This is managable, especially given the comparatively low level of Russian sovereign debt to GDP. However, as the World Bank point out under the likely scenario of a sluggish global recovery and modest growth, Russia will face a tightening budget constraint and need to reduce expenditures and the fiscal deficit over the medium term. Further, funding the planned increase in social expenditures, mainly related to increases in pensions, may well requires spending cuts in other expenditure categories.

The Ministry of Finance baseline federal budget estimates with conservative oil assumptions icorporate plans to reduce the federal budget deficit from 8.3 percent of GDP in 2009 to 3 percent in 2012, but the medium term fiscal outlook also indicates an extensive drawdown of Russia's Reserve Fund to finance the deficit. Given the size of the anticipated deficit, the Reserve Fund is likely to be depleted by the end of 2010 and borrowing will be required to offset the gap. Estimates of the Ministry of Finance indicate that the combined external and internal borrowing to cover the fiscal deficit will amount to 1.0 percent of GDP in 2009, 1.6 percent in 2010, 2.5 percent in 2011, and 1.5 percent in 2012. All of this is manageble, but the depletion of the Reserve Fund does mean that if downside risks materialise, and in particular if there are more writedowns in the banking sector needing government support that there is now little in the way of a cushion between managed adjustement and unstable dynamics.

Outlook – A Hard Road To Travel

If one thing is clear hear it is that attaining a recovery in Russia's economic fortunes at this point is going to be no easy feat, as Trust Investment Bank put it in their latest report, October data for the world’s largest energy exporter suggest “an almost complete absence of clear signs of recovery” since industrial output slumped and capital investment fell. October capital investment was still down 17.9 percent while industrial output dropped an annual 11.2 percent in October worse than the September reading. Even unemplyment was up again, at 7.7%, although as the World Bank pointed out, this is the result of the same seasonal factors which lead to the fall in unemployment over the summer.

On the other hand, this is by no means a one way street, since disposable incomes climbed a monthly 6 percent in October and rose 3.9 percent compared with the same period last year, registering their biggest annual jump since September 2008, according to provisional data from the Federal Statistics Service, while wage declines eased with wages falling an annual 4.5 percent, compared with a 4.9 percent annual decline in September. And retail sales, which had previously fallen for nine consecutive months, the longest period of declines on record, suddenly sprang back to life, with October retail sales rose 3.2 percent from September and declined by 8.5 percent on an annual basis as compared with a 9.9 percent drop the month before.

Other data also show this mixed picture. Monthly GDP Indicator data from VTB Capital, based on the PMI surveys for the Russian manufacturing and service sectors, continued to show economic contraction on an annual basis in October, butthe rate of decline eased for the fifth consecutive month. The Indicator showed a 0.6% annual contraction, the slowest rate seen suring the current eleven-month period of continuous decline.

The seasonally adjusted Total Activity Index remained above the no-change mark of 50.0 for the third month running in October, indicating growth of private sector output. The Index improved fractionally over September, to 54.2, indicating reasonably robust growth (although it remained below its historic trend of 56.6). This was driven by a faster rise in services activity, while the rate of growth in manufacturing production slowed to a weaker pace. On a quarterly basis the indicator showed 0.4% q-o-q growth for the second month running.

““The GDP Indicator continued to point to an improvement in economic activity in October. The manufacturing sector’s performance deteriorated slightly while activity in the services sector is approaching pre-crisis levels. This might be one of the consequences of higher oil prices and a stronger rouble as low export orders were the main drag on manufacturing. Another encouraging development highlighted by the October surveys was the deceleration in the pace of job cuts: the employment sub-indices now stand at around 47, which is already higher than last autumn.

The GDP indicator reading was based on manufacturing sector survey findings which confirmed that overall Russian manufacturing business conditions deteriorated in October. Although output, new orders and input purchases all continued to grow, the rates of expansion slowed compared to September. Moreover, manufacturers shed jobs at a faster pace than in September.

The headline seasonally adjusted Russian Manufacturing PMI fell from 52.0 in September to 49.6 in October, signalling an overall deterioration in the business climate at the start of the fourth quarter. It was the first month-on-month fall in the headline index since it plummeted to a record low (33.8) in December 2008, although the latest figure was indicative of only a marginal rate of decline. Of particular note, the new export orders index posted a strongish decline to 47.8, evidently reflecting the recent ruble appreciation. The input price index continued to point to strong rise in costs associated with metals, energy and oil-related items while output prices index pointed to a moderating growth in price charged.

In contrast the rebound in Russian services activity rose continued in October, supported by a record fall in charges, and Russia's services sector, which accounts for about 40 percent of the economy, rose for the third consecutive month, reaching its highest level since September 2008, although the reading of 54.3 still remained significantly below the long-run series average.

So Where Do We Go From Here?

In contrast to the most recent PMI data and the opinions of analysts like Neil Shearing at Capital Economics and Trust Investment Bank , Russia's political leaders are markedly more optimistic. Russia’s economy may expand as much as 4 percent in the last quarter of 2009 following a timid return to growth in the third quarter, according to Deputy Economy Minister Andrei Klepach speaking at a conference in Moscow recently. The economy may show “quite strong growth” of between 3 percent and 4 percent in the fourth quarter over the previous three months, Klepach said. This is an interesting claim, and doubly so given that Klepach has been quite cautious so far this year in his claims. However, as Neil Shearing at Capital Economics points out Klepach’s claim that growth could rise to an annual 4% at some point is perhaps not as wild as it first sounds. Shearing estimates that output fell by over 9% between Q4 2008 and Q1 2009, which means that given the sizeable base effects which will exist the Q1 2010 year on year growth rate might well look look quite impressive.

But this may be a kind of "mirage effect" since if the global recovery slows towards mid-2010 (and with it the level of energy prices) then Russian annual growth could easily fall back sharply over the second half of next year and into 2011. Thus the prospect of a renewed fall in energy prices would imply that the risk a double-dip recession in Russia is quite a real one.

But this is all for the future, while here in the present the rising price of oil and the return of some financial flows into Russia continues to fire-up optimism, as do the numbers for retail sales, so we had better just grit our teeth and hope they don't also fire up the inflation process again, although with lending to households still stuck in gridlock, perhaps the dangers here should not be overstated. More worryingly, inflation may fail to fall significantly from its current high level, even as the central bank reduces interest rates in a bid to stem the ruble rise.

Klepach's optimism is not shared, however, by the World Bank who in their latest report argue Russia’s economy will suffer a deeper contraction than they previously estimated this year even after a series of central bank interest rate cuts which have manifestly failed to ease the “prolonged” credit drought. The World Bank now expect the Russian economy to contract by 8.7 percent this year, compared with their June forecast for a 7.9 percent decline. The government is currently predicting the economy will shrink 8.5 percent this year and grow 1.6 percent next year.

“We expect that the central bank will continue lowering its policy rate in the near future to facilitate credit to the real sector,” the World Bank said. “The impact, however, appears to be limited. The policy rates are mostly indicative, while the cost of credit remains very high.”

The OECD, on the other hand, seems rather more positive, arguing that Russia’s economy will enjoy a stronger commodity-driven rebound than first estimated, although, they hasten to add, authorities should avoid a sudden removal of stimulus measures to ensure the domestic economy keeps up the pace of its advance. They now expect the Russian economy to expand by 4.9 percent in 2010, compared with a June forecast for 3.7 percent growth, although output is still expected to contract 8.7 percent this year (broadly in line with the World Bank), more than the 6.8 percent estimated in June. The 2010 figure seems very optimistic in the light of the problems here identified, and more than adding to our appreciation of the Russian situation such numbers may rather cast doubt on the methodology being applied, and raise questions about some of the numbers being seen for other countries.

“Although recovery is in prospect, the large output gap and subdued inflation suggest that policy stimulus should not be removed too hastily,” the OECD said. “Fiscal policy should be managed to avoid dislocative demand effects from a surge of expenditures in late 2009 followed by a tightening in 2010.”

According to the OECD, Russia’s economy will enjoy a stronger commodity-driven rebound than first estimated and “Fiscal and monetary stimulus and the recovery of global demand should result in a strong rebound of output towards the end of 2009". The basic OECD argument is that “A large part of the policy stimulus will be felt only late in the year, as fiscal expenditure is back-loaded and a series of interest rate cuts began only in the second quarter.”

Long Term Impact On Russian Growth

But let us not underestimate the difficulties. According to the World Bank Russia’s real GDP will likely return to pre-crisis levels only in late 2012. And, the Bank says, without a more productive, diversified, and competitive economic base, its long-term growth is likely to be slower than in the past decade and than the pre-crisis expectation

Russia’s pre-crisis decade of prosperity was built on strong capital inflows, rising consumer and corporate credit, and significant capital investment. The post-crisis world will look very different: Russia will need to implement fiscal adjustment and diversify its economy in the context of sluggish global growth, low capital flows, and more limited access to foreign financing. So it is now time to look towards a new growth model based on increases in productivity and know-how and on more efficient allocation and use of investment, labor, and FDI. Next generation reforms should be geared to make Russia's monetary policy instruments much more effective, the Russian economy much more productive, diversified, and open—and more able to respond to future shocks. The success and duration of the transition from the current model of heavy dependence of natural resources to a more sustainable growth model depends, according to the World Bank on maintaining a competitive exchange rate, sustaining a prudent fiscal stance, improving the investment climate, more mobile capital and labor, making the financial sector deeper and more efficient, investing in infrastructure to eliminate key bottlenecks to growth, and strengthening governance and fighting corruption as part of the overall effort to improve the effectiveness of the public sector.

The OECD more or less agrees: “Laying the foundations for sustained rapid growth will require unwinding some of the distortive consequences of the crisis". And, may I add, unwinding some of the distortive processes which lead the crisis to be such a severe one in the first place might not be such a bad idea either.

[Update: Ok, that was an unduly quick write-up; the worst spelling errors and typos have been corrected accordingly]

Although I certainly would not rank it alongside Macro Man's dreaded vacation indicator or the incipient increase in the USD if and when the Economist finally decides to slot its decline on the front page, I still have the nagging feeling that whenever yours truly sit down at either a dull and difficult econometrics lecture or, as today, camps at school for a lab session in connection with a paper due next month, some event is bound to wreck havoc on markets while your author is busy estimating regressions. I would assume that some US market participants feel the same today as they give thanks before hauling in the Turkey.

In any case, this time around the skeleton that could be kept in the closet no longer is neither Baltic nor Spanish; it is Middle Eastern. At this point, I am of course simply trying to get an overview like the rest of you and not least deciding whether it will have any far reaching repercussions beyond today's theatricals. However, in case you did not turn on your Blackberry today, they story is that the Dubai government has requested investors in the debt of the investment company Dubai world whether they wouldn't be so nice as to accept a wee postponement of the payment of their debt. Especially, a payment due already the 14th of December in the form of $3.52 billion of bonds from property unit Nakheel PJSC looks as if it is near dead in the water.

(quote Bloomberg)

The price of Nakheel’s bonds fell to 70.5 cents on the dollar from 84 yesterday and 110.5 a week ago, according to Citigroup Inc. prices on Bloomberg.“Nakheel is now standing on the brink of failure given the astonishing amount of cash Dubai would have to inject on it in order to see the enterprise survive,” said Luis Costa, emerging-market debt strategist at Commerzbank AG in London.

Obviously, announcements of delay of debt payments smells an awful lot like default and with $59 billion worth of liabilities at Dubai World many a financial institution and investor are exposed here. Naturally, and apart from the internal mess this is likely to cause in the Middle Eastern region, I am looking closely at the notion of European banks being sucked in here too.

(quote Bloomberg)

The biggest creditors are Abu Dhabi Commercial Bank and Emirate NBD PJSC. Other lenders include Credit Suisse Group AG, HSBC Holdings Plc, Barclays, Lloyds Banking Group Plc and Royal Bank of Scotland Group Plc, according to a person familiar with the situation. Barclays slumped as much as 6.9 percent, the biggest intraday loss in a month, while RBS sank as much as 8.3 percent. Lloyds and Credit Suisse dropped more than 3 percent.

As ever, it will be most interesting to see which adventures European (and indeed US) financial institutions have been engaged in with the cranes of Dubai and thus how much more junk they will now have on their balance sheet (question: does the ECB by chance have collateral from Dubai World in the tank?!).

Naturally, this may all get a happy ending for the creditors if a) the Dubai government decides to foot the bill through a massive liquidity injection and b) it does not default in the process. Since the government itself, it appears, took part in suggesting the repay delay/restructuring the stakes were raised already from the get go especially as both Moodys and S&P have indicated, initially through massive cuts of companies and funds in the region, that they might consider the move to ask investors for a delay in repayment as a defacto default; a statement which together with the state of play naturally have seen credit default swaps soar for both sovereigns and companies across the region.

Globally, the reaction was equally strong with stocks across the board taking a hit and yields on developed economy government bonds dropping to reflect the knee-jerk move into "safety" assets by part of global investors. In this respect, I agree with the underlying sentiment expressed by Russel Jones from RBC Capital markets

(qoute Bloomberg)

“Dubai isn’t doing risk appetite any favors at all and the markets remain in a vulnerable state of mind,” said Russell Jones, head of fixed-income and currency research in London at RBC Capital Markets. “We’re still in an environment where we’re vulnerable to financial shocks of any sort and this is one of those.”

The key here is exactly whether this merely reflects the fact that markets and risky assets are naturally nervous and thus how it takes only a small (or large?) disruption for risk aversion to decline or whether there is a stronger and more structural theme at play here with respect to the potential real contagion the events in Dubai might have. At this point I am leaning towards the former simply because I have no reason or knowledge to claim the latter. I suspect that minds more informed than me will let us know soon enough as well as any untold stories will surface sooner rather than later.

More importantly (at least for me), it was interesting to see that old habits still linger in the context of FX markets;

(quote Bloomberg)

The yen climbed as high as 86.30 per dollar, the strongest since July 1995, before trading at 86.60. The U.S. currency strengthened against all but the yen among its 16 most-traded counterparts, appreciating 2.6 percent versus the New Zealand dollar and advancing 2.4 percent against the South African rand.

The Swiss franc weakened as much as 0.3 percent per euro, falling from the highest level since June, on speculation the Swiss National Bank sold the currency to curb its gains. The franc dropped 0.9 percent to 1.0057 against the dollar after yesterday reaching parity for the first time in 19 months. The SNB declined to comment.

Now, whether this is a story of unwinding of carry trades and low yielders reacting to risk aversion as I have tended to interpret it (a position which Cassandra, by the way, recently calleddisingenuous at best and ludicrous absurd puerile) or simply, as would be Cassandra's point, systemic deleveraging and thus a retrenchment of funding liquidity (primarily in USD) is an open question which I intend to deal with in more detail in the future. For now, it will suffice to say that the USD acts as a carry trade funder along side the JPY with the Swissie apparently still supported by the bullying of the SNB. In short, if it walks like one and quacks like one ... well.

For more background on Thursday's Dubai Delights we can thank the job rotation schedule at FT Alphaville for having Izabella Kaminska at the rudder (among others) as she has been relentless digging up background and information on the situation in Dubai throughout the day. Over and above the tragicomic allure of the failed conference call scheduled for bond holders of Nakheel (a guy called Murphy springs to mind), I take notics of the "sterling connection" and specifically the idea that the Pound may suffer from the Dubai rout as the sheiks and the rest of their ilk will be forced to sell UK real estate assets (time to buy a Chelsea pent house then?) in order to kick up the funding needed. Here is Izabella;

In other words, if default is really on the cards, chances are Dubai World will have to start a major fire-sale of assets. Unluckily for the UK, the Middle East and the UAE have for a very long time viewed the British real-estate market as a safe-haven investment.

Whether the inflows from the window shopping of super affluent Middle Eastern investors in the UK real estate market have been a marked driver of the exchange rate is debatable, but Izabella digs up some comments by BNP Paribas who certainly seems to think that this is the case. So we better watch that one too then. Finally, Izabella headbuts Barclays Capital by juxtaposing an old note dated back only this month in which BC recommends a long position in everything debt related to Dubai (Sovereign as well as Corporate) with a more a current note in which this argument is, uhm, relaxed. A cheap shot you might argue ... perhaps, but fun and interesting nonetheless.

Dubai Delights No More?

I have to say that it was not without a bit of the old Schadenfreude that I loaded up Bloomberg and Reuters this afternoon to learn that Dubai seems to be facing a great unravelling. We still need to get to full story of course at this point, and if the Dubai authorities step up, it may all turn out to be a storm in a tea cup. However, on a personal note the "Cranes of Dubai" always represented one of the clearest example of the excess and froth observed in the context of the economic boom that ended abruptly with the current financial crisis. With this in mind I am not the least surprised about this which of course is easy to state ex post, but then you choose whether to believe me or not.

More generally, it need not, naturally, put an end to financial and economic development in the region, but it is one thing to have and collect commodity windfall and quite another to spend it wisely and to productive means. One would hope that this serves as a timely reminder as we move on from here.

Sunday, November 22, 2009

"In my view … it is impossible to understand this crisis without reference to the global imbalances in trade and capital flows that began in the latter half of the 1990s." Bernanke (2009)

Executive Summary

Compared with the average quarterly value of GDP in 2007-08, the first two quarters of 2009 are down in nominal terms to the tune of 15.9%, 15.4% and 10.5% in Lithuania, Estonia, and Latvia respectively.

The average quarterly current account deficit of the Baltics from Q3 2008 to Q2 2009 was mill 500 Euros. This amount to just 18% of the average quarterly current account deficit two years prior to the crisis. Consequently, the Baltics have delevered to the tune of 80% over the course of less than 1 year.

In the two first quarters of 2009 (relative to Q1-2006 to Q4-2008), imports have contracted 16%, 33% and 11.5% more than exports in Lithuania, Latvia and Estonia respectively.

In Euro terms, the Baltics have lost external financing to the tune of bn 1.87 Euros in the first half of 2009 compared to the peak of the boom which amounts to 12.6% of the entire region's GDP in the same period.

The quote above from Fed chairman Bernanke is ripped from the introduction of a recent conference paper drafted by international economics icons Kenneth Rogoff and Maurice Obstfeld who suggest that the financial and economic crisis that is currently making its presence felt across the global economy, at least in part, has something to do with the notion of global current account imbalances. Now, and in all modesty, this is something I have argued extensively at this space and in this way I welcome the likes of Messieurs Rogoff and Obstfeld in the fold. I tend to go, of course, for the big prize in my stubborn persistence on the link between global ageing, global imbalances and thus by way of deduction the economic crisis as we have come to know it.

Now, I am not going to treat this link here but merely point to the rather obvious question at this point in time, in the form of whether in fact the crisis itself has been a catalyst of re-balancing? At a first glance this would clearly seem to be the case. In a crisis driven decisively by a violent process of deleveraging, those economies who had hitherto relied on borrowing have now been forced to scale back (and essentially correct either through a debasement of their currency, internal price correction, or a combination of these two) and the nations that had delivered the funding have likewise been forced to accept that their external surpluses have shrunk in a comparative manner.

So far so good then, but what happens when we have to get the patient out of intensive ward; who will run the deficits and surpluses and what size will the imbalances, if any, be. This is a difficult question to answer, but it appears that with the US economy now being effectively forced to correct its external imbalance (be it with Europe, China, Japan et al kicking and screaming or not), we have a situation with a lot of would be exporters and very little importers.

If this is the general set piece, it was with some interest that I read this VOX.eu piece by Mr. Richard Baldwin and Ms Daria Taglioni which dryly submits the thesis that although it may appear that rebalancing is occurring, this is only as a byproduct of the crisis. From ther horse's own mouth;

Global imbalances are shrinking at a fabulous rate. This column argues that these improvements are mostly illusory – the transitory side-effect of the greatest trade collapse the world has ever seen. A global recovery will almost surely return the US, Germany, China and others to their old paths.

Not exactly the prospect we were all hoping for, but in the main I agree with this point except of course the small and important qualifier that the US economy will have to deleverage and reduce the external (and indeed internal) borrowing. Whether Germany, Japan, China will also need to export ... well, this is ultimately a question of finding a customer.

Rebalancing the Baltics?

The obvious question to arise at this point is obviously what all this has to do with the Baltics? Well, in a direct sense not a whole lot since as the Economist so famously put it, the Baltics remain piqsqueaks and whether we observe current account positions, of either negative or positive pedigree, at some 20% of GDP it won't do much to affect the global imbalances. However, in the light of the idea of rebalancing on the back of the economic crisis and whether this is sustainable let alone feasible, the Baltics become very interesting not least since they have chosen (or have been led into) a process of rebalancing through internal price deflation (devaluation) as their currencies, for now, remain fixed to the Euro. In that vein, I thought it interesting to have a look at how the Baltics have faired so far with a specific focus on the external balance.

Beginning however with a general view of the correction so far the picture is definitely one of a hard landing on the back of the economic crisis.

Most of the readers of this space will be well acquainted with travails of the Baltic economies (and in particular, the near collapse observed in Latvia earlier this year). In all three Baltic economies the Euro value of their GDP peaked in 2007-08 and has since fallen back dramatically. Compared with the average quarterly value of GDP in 2007-08, the first two quarters of 2009 are down in nominal terms to the tune of 15.9%, 15.4% and 10.5% in Lithuania, Estonia, and Latvia respectively. The Baltic economies have lost bn. 2.2 Euros worth of GDP in 2009 from the GDP output observed in 2007-08 which amounts to a loss of some 21% of the average value of the quarterly GDP output for all Baltic economies combined from 1999 to 2009. In short; these economies have taken some blow to the kidneys and even if we can safely say that the levels of nominal GDP observed in 2007-08 were unsustainable the way down is still rough, very rough.

On the price front the correction has indeed begun and the graph above actually underestimates the current bout of price deflation as it smoothes away, as it were, the fact all three Baltic economies are in deflation on a m-o-m basis. Only Estonia registers deflation on my representation with Latvia basically hovering at the 0% line and Lithuania still producing inflation rates at some 2%.

Moving on to the external balance it is worthwhile splitting up the analysis by having a look at first the import/exports picture and then grinding down to the income level and finish off with a look at the financial accounts and thus the inflows used to finance the deficit (or how the surplus is invested abroad).

This is perhaps the best picture of the Baltic correction there is and nicely illustrates the point emphasised by Baldwin and Taglioni that the correction of imbalances, at this point in time, has been very much forced upon the deficit economies. Consider consequently the average quarterly current account deficit of the Baltics from Q3 2008 to Q2 2009 at mill 500 Euros; i.e. at the point when the crisis made its mark decisively.This amount to just 18% (!) of the average quarterly current account deficit two years prior to the crisis. This means that the Baltics have delevered to the tune of 80% relative to the level of the current account deficit observed up to the crisis. Again and with the benefit of hindsight, we know that these levels were unsustainable, but please do remember that it was only back in the H02 2008 that we were discussion whether the Baltics were going to have a hard or a soft landing. It is remarkable to note the example of Latvia here which has gone from a current account deficit of -17.6% of GDP in the period 2007-08 to a current account surplus of 14% of GDP (mill 681.3 Euros) in Q2 2009 due mainly to the fact that imports and GDP have plunged.

This point in particular is important to emphasize since the extent to which we are able to talk to about a sustainable (or benign if you will) process of rebalancing rather than one entirely driven by a sharp correction in internal demand and thus imports. The intuition tells us that Baltics are currently subject to the latter form of rebalancing and thus it remains to be seen whether there is a virtuous circle of increasing competitiveness and rising export shares (and values) on the back of the current vicious circle. But just how vicious is the current circle then?

The graph to the right attempts to answer this question as it plots the equally weighted average of the evolution of exports and imports in the Baltics. The time series corresponds to the value of exports and imports in million of Euros of the three Baltic economies and is indexed with the average quarterly value between Q1-1999 and Q2-2009 of imports and exports as 100.

The graph easily shows how imports have contracted much more than exports and it is consequently here that we must look for the driver of rebalancing in the Baltics. If we take Q1-2006 to Q4-2008 as the peak of the boom (in terms of the external deficits), exports are down 10.8% in the first half of 2009 whereas imports are down a full 33.4% in the same period. This suggests that more than anything that rebalancing in the Baltics are currently driven by a sharp contraction of domestic demand. Splitting up the result on the three economies and looking exclusively at the second quarter of 2009, imports have contracted 16%, 33% and 11.5% more than exports in Lithuania, Latvia and Estonia respectively.

Another way to look at this is to approach the external deficit from the financing side and consequently have a look at the inflows used to finance the external deficits. In principle, you would normally and in the perfect world mainly look at portfolio and investment flows, but in the case of the Baltics we cannot neglect credit flows which, through all those Euro denominated loans supplied by Scandinavian banks, have been instrumental in driving the external deficits during the peak of the boom. If we begin with the inflows as a share of GDP we observe the drastic way in which the financing have been withdrawn in the context of the crisis.

Observe in particular the Latvian situation where an external surplus has been forced upon the economy, proxied here by "negative" inflows and thus outflows. In Lithuania, the total sum of important inflows had declined, as a share of GDP, to 60% in Q2-2009 relative to value recorded during the peak of the boom (Q1-2006 to Q4-2008). The corresponding figure for Estonia is 23% whereas for Estonia it has changed signs all together due to the fact that financing here has come to a complete standstill. In Euro terms, the Baltics have lost external financing to the tune of bn 1.87 Euros in the first half of 2009 compared to the peak of the boom which amounts to 12.6% of the entire region's GDP in the same period.

As noted extensively above, this process is natural since we can say with some confidence that whatever the level (and flow) of incoming investment and credit during the peak years it was not sustainable. However, when it happens with such force in the context of the global financial crisis and, moreover, in relation to fixed exchange regimes and thus internal devaluation the obvious question that begs is what the risk is of pushing these economies into a hole from which they cannot emerge. One particularly important point here is what kind of general (and domestic!) credit and financing environment we will see as the external funding is ground down and thus, in some sense, what kind of domestic environment the Baltics will have to stage a recovery in.

This last point is perhaps the most important underlying theme to think about when assessing the situation in the Baltics. We could almost say that the extent and pace to which the Baltics' growth path has crumbled is also the extent to which expectations of convergence, Euro membership, underlying growth potential etc have crumbled. Where we go from here is consequently anybody's guess. A lot of unresolved question still clouds the horizon not least the continuing unravelling in Latvia where the IMF has so stuck with the country despite the increasing dire outlook as long as the currency peg remains. What I can tell you however is that the Baltics are going to rebalance, but the key is the extent to which it happens so as to allow the Baltic economies to enter a virtuous circle somewhere down the road.

So far, a preliminary assessment suggests that while the Baltics are indeed rebalancing, they are only doing so because internal demand has caved in. We are yet to see whether the dose of internal devaluation/deflation will bring back competitiveness in due time to turn a vicious cycle into a virtuous one.

Sunday, November 15, 2009

Sorry, and I apologise in advance: in this post I'm going to be a nit-picker. The question in hand is the Eurozone third quarter growth one, and the story is all about differences (between countries) and these differences in the key cases (France and Germany) are in many ways all about inventories. So maybe I should have titled the post "all about inventories", following Pedro Almodovar's cinematographic lead in cycling and recycling that old "all about Eve" metaphor - necessity is the mother of invention, and movements in inventories are progenitors of both growth, and of that notorious double dip difficulty. So just which one of these is it that we have on our hands here?

Indeed, the fact that the devil, as always, lies in the details should not really surprise us since economics isn't that different from other sciences, and isn't such a difficult subject to work with - even if some journalists and lot of bank analysts are able to make it look like it is by managing so frequently to make a dogs dinner out of what should really been an ever so plain, ordinary, and simple vanilla-flavoured ice cream. Let me explain.

Before getting bogged down in all that horrid detail let's register a very simple plain, evident, and totally undisputed item of fact - the "eurozone sixteen" economy (whatever that rather nebulous concept actually refers to, when you dig down a little below the surface) poked its nose timidly out of recession in the third quarter of this year, with gross domestic product in the 16 countries using the euro rising 0.4 percent from the previous quarter (see chart below). This return to positive headline growth technically brings a recession which lasted five consecutive quarters of shrinking output to a close - even though output was still four percent below that registered in the same period in 2008. So evidently we are out of recession, but are we out of the woods yet?

Well, basically I think we aren't, and to explain why I think we aren't I'm going to pick (yet one more time) on poor old Frank Atkins of the Financial Times. It almost hurts me to do this, since I am not trying to say that Frank is an especially bad example of economic journalism (far from it), even if he is sometimes very badly served by his headline writers, writers who over the weekend managed to switch what was Friday's declamatory "Germany powers eurozone recovery" version (and for those who like twitter here) to Sunday's much more modest "European recession ends with a whimper" one. However since this is now the second time in just over as many months that Frank has wheeled out the German economy "powering" something or other word out, I cannot help concluding that either he really likes the expression, or that he must know something I don't about what is actually going on in Germany, since structurally speaking it would seem to me that such "powering" is now completely impossible, given the economy's evident export dependence.

Thus far from powering up anything, the German economy is always - in some significant and non-trivial sense - going to be "powered" by someone or somewhere else. The thing about Frank is - in Eurozone economic terms at any rate - he is both geographically very close to where the action is (ie in Frankfurt), and communicationally very much in touch with thinking in Brussels and Frankfurt, which is what always makes what he has to say interesting, at the very least. On the other hand, since the journalistic consensus seems to have shifted over the weekend - quite literally from a bang to a whimper - we might really want to ask ourselves the tricky question of whether we still think the rebound is as strong as it was first made out to be.

"Germany’s economy expanded by 0.7 per cent in the third quarter", Frank told us (in Friday's version) "marking a sharp acceleration in the pace of recovery in Europe’s largest economy, but the pick-up in France fell short of expectations."

Well, here we have two facts - the Germany economy did grow by 0.7%, and growth in the French economy was below consensus expectations - and one opinion, that the growth represented a sharp acceleration in the German recovery. In fact, in France output expanded by 0.3% in the third quarter, a very similar pace to that seen in the second quarter, but significantly below consensus expectations which were for a 0.6% growth rate.

But really the issue this raises isn't actually one about the French economy at all, but about how the economists in question managed to talk themselves into having such ludicrous expectations, and about what methodology exactly it was they were using to arrive at them. Certainly I am a leading "bull" on the French economy, but I never came anywhere near the quoted number in my estimations, and indeed in my most recent full analysis of the French economy, published 27 October last on A Fistful Of Euros and elsewhere, I actually said this:

"French GDP surprised positively with a 0.3% quarterly gain in the second quarter. Given the data we are seeing, a forecast of 0.2% quarterly growth for both the third and final quarters would not seem to be an unreasonable expectation at this point, which would mean the French economy would shrink by something under 2.5% in 2009, well below the average Eurozone contraction rate."

So you could say, rather than being disappointed I should have been rather surprised on the upside by the outcome, since growth at 0.3% came in higher than my expectation (0.2%). But truth be told, I really wouldn't want to make this claim very strongly, since I was in fact practicing what we Catalans call the ancient art of "trampa" (astute trickery), sin being intentionally excessively prudent in order to outperform, and also trying to shift attention away from the short term headline number issues about this quarters French GDP number to the longer term issue of what happens to monetary policy in a "Eurozone 16" if France recovers significantly more sharply than everyone else.

Before continuing further, I would also make a second point, one which I think is pretty relevant to the whole debate about where the Eurozone actually stands in the here and now, and that is that my most recent piece was actually written about the OCTOBER PMI data, that is I was already looking ahead and talking about prospects for the fourth quarter, whereas Friday's release was actually backward looking, and taking us back in time, in order to revisit not Brideshead, but economic data from the third quarter in an attempt to get a better picture of what was happening back then, even if, as we are now about to see, since Friday's release was only a "flash" one, we still lack most of the detailed breakdown which would enable us to do just that. So in many ways Friday's news was already history (which makes it even more surprising how consensus interpretations have shifted over the weekend) and what really interests us is what is happening now, and where the current so called "recovery" is actually heading. And just to rub our noses right in it, we could remember that a week on Monday (23 November) we will have the Markit Flash PMIs for November (and this will already give us two thirds of the fourth quarter data to play around with, which should help us come up with quite realistic estimates of what eventual GDP will look like).

Thus, despite my openly professed French "bullishness" I do want to stress that I am only expecting modest growth again from France in the fourth quarter, but the important point we should expect this growth to be sustained going forward, and it is this that makes France so different from much of the rest of the Eurozone, since France has the capacity to generate autonomous (endogenously driven) growth in consumer demand and it is precisely this feature that makes the French economy so special (in the Eurozone context) at this point. Anyone looking for dramatic (sustained) surges in the any of the advanced economies at this point is, basically, living on another planet (possibly, I suspect, the one we are all being expected to send our exports to).

"In a quarter-on-quarter comparison, when adjusted for price, seasonal and calendar variations, especially exports as well as capital formation in machinery and equipment and in construction had a positive impact on growth. However, a large quarter-on-quarter increase was also recorded for imports which, among other things, led to a build-up in inventories. Final consumptionexpenditure of households, however, was down and slowed down economic growth."

Now if you look at the chart below, you will see that German growth was in the second quarter was, more than anything, a statistical quirk which resulted from a balancing act between strong swings in inventories and in net trade. In the third quarter, as far as we can see (since we don't have that ever so important detailed breakdown), this position has quite literally been inverted, as the earlier trade bonus has been eaten away by growth in imports (largely to stock up on export oriented inventories, not items destined towards domestic consumption) and this part we more or less know, since we do have all the trade data in for the quarter.

So we need to see the magnitude of the German inventory shift, and then we can get an idea of how much this could unwind in Q4. The current position reminds me very much of Q1 2008, when Germany put in a record annualised growth rate (1.7% q-o-q, 7.2% annually) only then to slouch off into recession and four consecutive quarters of GDP contraction. One reason for this surge in GDP, then, was that the huge growth registered was a by product of a massive inventory pile-up (see chart), a pile up which was precisely the result of an anticipated continuation in demand, demand which, as it happened, never materialised.

Now the current position is not as bad as Q1 2008, since the size of the distortion is not so great, and the general external environment may be more supportive in Q4 2009, but still I think the general structural point holds. Indeed the October PMI suggests inventories are coming down again, with Markit reporting that "companies remained cautious regarding input buying and stock levels" and that the "October data showed that both inventories of purchases and finished goods fell sharply over the month". Finally, we should not let this last point from the German Federal Statistics Office Report escape our notice, since at the end of the day it holds the key:

"Final consumption expenditure of households, however, was down and slowed down economic growth."

So now, by way of comparison, let's turn our attention to France, and see what was actually happening there. Now, according to the quarterly report from analysts at Nomura:

"France is the only country to publish a components breakdown and the details are disappointing, with domestic private demand still very depressed. Most of the growth came from public spending and net trade; private consumption was flat, while fixed investment from firms and even more from households retrenched heavily. Inventories continued to decline."

Now the Nomura people say "with domestic private demand still very depressed", but, I'm sorry, if you take a look at line three in the table, which shows quarter on quarter household consumption, you will see this is stable, and up. In fact France has not shown one single quarter of quarter over quarter contraction in household spending during the whole crisis. This is what I mean when I say robust. Now you could say that this is all about cash for clunkers, and to some extent you would be right, but other countries have had cash for clunkers programmes, and domestic consumption hasn't held up anything like as well, so the outstanding issue for economic theory, and for eurozone monetary and fiscal policy, is why, why does the French economy and none other exhibit this profile?

Now you might want to argue that French household consumption was stationary in the third quarter (and this is what many of the analysts point to), but I would respond by pointing out it is still well up on consumption in the third quarter of 2008 due to the earlier quarters of growth. OK, so we don't exactly have a consumption boom (yet), but is anyone really expecting one at this point? Even in Norway? All I am saying, and saying almost boorishly, to the point that it irritates, is that French consumption has the potential to rise in the coming quarters, while German consumption doesn't, and this is going to be the key FACT about the Eurozone in the months and quarters ahead. And if you find economic at times a boring and tedious subject, then I'm sorry, sometime things are just like that.

And please, please, note this: "Inventories continued to decline."

Look at the next to last line in the table. French inventories fell by 1.5% quarter over quarter. So, to put things plainly, the real difference between those headline GDP numbers for Germany and France is that Germany increased inventories while France ran them down, and government spending in both cases played a large part in the growth. The thing is, in the fourth quarter it is quite likely that Germany will have to run down some of those inventories, while France may start to increase them. Either way, I repeat, at this point French growth (even if at a tortoise pace) looks a lot more robust and a lot more sustainable than growth in any other Eurozone country, and if things turn out as they appear to be, then we will one more time need to be asking ourselves just what it is that is wrong with "convergence theory", since whatever the actual reason behind the present Eurozone divergences, the plain fact of the matter is that they exist.

Conclusions

Basically if we go back to the weekend version of Frank Atkins article, the real powerhouses of the rebound are not France, but, and would you believe it, Germany AND Italy.

"Powering the rebound were Germany and Italy, which saw GDP rising by 0.7 per cent and 0.6 per cent respectively. France’s recovery, however, proved much weaker than expected, with an increase of just 0.3 per cent, the same as in the previous quarter."

Now Germany I can swallow, there is a real issue there about just how far forward Germany can leap, but Italy? I ask you. Let's have a look at Italy's long term growth chart:

My estimation is that Italy's long term trend growth at this point is not far from zero, and indeed it is quite possible that Italy could have its third consecutive year of negative growth in 2010. Italy's growth problems are well know, structural, and long term, and have little to do with the current crisis, so any argument about Italy powering anything very significant at this point, is bound to be skating on thin ice. And then, of course there is Spain, which isn't getting too much mention, but which is consistently likely to pull the Eurozone 16 aggregate growth number down going forward. FT Alphaville's Tracy Alloway draws attention to a summary of the situation from JP Morgan economist David Mackie which seems pretty much to the point.

"The third quarter GDP data suggest that the region has exited recession, but the move was hardly a decisive one. Despite a 12% annualised rate gain in industrial production across the region, GDP managed to increase by only 1.5% annualised rate. Clearly, there was a lot of weakness in construction and services. These data will reinforce the perceptions of the consensus: that the upswing will be lackluster and bumpy. And, they present a major challenge to our more upbeat forecast of growth over the coming year. Indeed, if GDP can only increase by 1.5% annualised rate when IP grows at a double digit pace, the largest gain since 1984, one can only worry about the future."

And as Tracy points out a number of Eurozone economies are still stuck in recession. Spain and Greece we know about, while Ireland, Slovenia and Finland have yet to report. Even the Slovak case is not entirely clear, since we have no seasonally adjusted data.

So, going back to my original question, is this a whimper recovery, or are we on the verge of a double dip? I think, basically, it is all down to Germany, and those inventories. If external demand weakens in key customer countries then Germany will fall back into negative growth, and with it the whole "eurozone sixteen economy". Since demand in the South and the East of Europe is hardly going to be strong, given the new found need of countries in those regions to run trade surpluses, my inkling is that just this outcome is now a clear possibilty. So while the consensus at the moment seems to be that France disappoints, my view is that it is the German economy we really should be worrying about.

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Claus and Edward's "Baker's Dozen"

Claus Vistesen and Edward Hugh are proud and happy to announce that they are now working as "featured analysts" with a new Boston-based start-up - Emerginvest.

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The oldest known source and most probable origin for the expression "baker's dozen" dates to the 13th century in one of the earliest English statutes, instituted during the reign of Henry III (r. 1216-1272), called the Assize of Bread and Ale. Bakers who were found to have shortchanged customers could be liable to severe punishment. To guard against the punishment of losing a hand to an axe, a baker would give 13 for the price of 12, to be certain of not being known as a cheat. Specifically, the practice of baking 13 items for an intended dozen was to prevent "short measure", on the basis that one of the 13 could be lost, eaten, burnt or ruined in some way, leaving the baker with the original dozen.